Livio Di Matteo: Modest fiscal rules could have saved billions in federal spending

Prime Minister Justin Trudeau will provide an update on COVID-19

In the wake of soaring deficits and government debt across Canada, spending restraint remains difficult for many governments. But can policy-makers — whether in or outside of government — redesign the policy process to limit growth in spending or taxation? Such rules or mechanisms — what economists call Tax and Expenditure Limits or TELs — restrict the growth of either government revenues or government expenditures.

TELs are more common in the United States where as of 2020 some 33 states featured some type of TEL, including strict restrictions on tax or expenditure levels or growth rates. This formula-driven approach often links spending growth to the growth of personal income or GDP or to inflation plus population growth. Another TEL method restricts spending to a percentage of projected revenue with a cushion in case revenues fall short of expected.

Effective TELs must be transparent in their construction with clear definitions and few exemptions. As has been noted in the U.S., TELs designed and established as laws or rules by legislative bodies tend to be less effective than those implemented via citizen-approved constitutional changes or amendments.

What are the key benefits of TELS? Obviously, they can restrain politicians and bureaucrats, who often have little incentive to control spending in response to pressure from interest groups. And smaller government (a potential result of TELs) can be associated with higher rates of economic growth: research shows that keeping government expenditure between 20 and 32 per cent of GDP has historically maximized economic growth.

With Canada’s federal debt now well over $1 trillion and federal budget deficits projected for years to come, how might a TELs policy have affected our current fiscal situation? As detailed in my new study for the Fraser Institute, if starting in 2015 we had had a fixed growth rule for federal spending, so it did not exceed Canada’s combined population-plus-inflation growth rate (approximately three per cent) then, in a no-COVID world, federal expenditures would have grown from $295.5 billion in 2015-16 to $393.2 billion by 2025-26 — much lower than the $466 billion projected in the Trudeau government’s 2021 budget. Under this scenario, federal finances would also have improved over time — from a budget deficit of $2.9 billion in 2015-16 to a $39.9-billion surplus by 2025-26.

Of course, a straightline projection like this does not consider that the economy rarely grows smoothly. Fiscal projections are never simple, given the potential for serious economic fluctuations. Over the last dozen years, we’ve seen a global financial crisis and recession, a big drop in the price of energy and, finally, the pandemic, which walloped both revenue and expenditure plans. Stuff happens. But, understanding that, it’s possible to structure a TEL that allows for a temporary suspension of the expenditure growth rule during economic shocks such as the economic contraction Canada experienced in 2020.

Had Ottawa followed the population growth-plus-inflation TEL since 2015, with a clause that allowed it to suspend the rule during a recession, the federal government could be heading to an annual surplus of $4 billion by 2025-26 rather than the projected deficit of $30.7 billion — even allowing for the COVID-19 spending of the last 18 months. In other words, if Ottawa had managed its finances more prudently since 2015, it could have delivered the exact same emergency fiscal support in 2021 and also balanced the budget by 2025-26.

Even a modest TEL or fiscal rule at the federal level could yield a lower trajectory for government expenditure growth, smaller deficits and lower accumulated deficits while also allowing for fiscal flexibly during severe recessions or emergencies. In short, a TEL would improve the fiscal performance of the federal government — a development most Canadians would surely welcome.